Thursday, October 30, 2008

In the last two to three decades, much of the emerging market economies veered away from an agriculture-led economy to a manufacturing-led economy. In recent years, some even started moving quickly into a service-led economy. In both cases, whether to a manufacturing-led or services-led, the impetus has been the growing globalization of business, where significant processes from the developed world were offshored to lower-cost sources.

What has been the result to agriculture in these areas?

Agriculture, as a percentage of these economies, slowly declined and garnered less and less importance to government decision makers. As higher-earning and higher value-added industries were born in the emerging economies, the relatively staid and low input agriculture sector lost both people and land dedicated to it.

Why agriculture lost people is evident, since higher-earning and higher value-added manufacturing-led or services-led industries tend to pay more for labor.

Why land dedicated to agriculture was lost was due to increasing productivity gains in the developed world, where technological advances and capital investments made in agriculture led to large surpluses in these countries, thereby taking out the competitive advantage of many underdeveloped countries due to cheaper labor. As food became cheaper because of the large surpluses being achieved by the developed economies, maintaining large tracts if land chiefly for agricultural purposes became less and less tenable for many poor economies. Thus, much of previously agricultural land were developed into industrial, commercial and residential areas.

As the emerging markets increased their respective GDPs, the industry and services sectors increased their share of GDP, while agriculture’s share dwindled. Everybody thought, all was well and good, for it was David Ricardo’s law of comparative advantage at work. Each country need only dedicate its people and resources to whatever economic pursuits best created value in the world economy relative to its neighbors, and they could now enjoy both a growing economy, and continued improvements in standards of living.

Who cared about agriculture? As long as the remaining agricultural areas of the world were still planting and reaping enough food for everybody, everyone can focus on doing more of what the world demanded. And what the world demanded were ever more and more mass-manufactured consumer items, and the increased business services that grew along with their explosive growth. Some previously agricultural exporters in the developing world were becoming net importers of food, as a result of the shift.

Now the world is expected to have a coordinated slowdown next year. The slowdown will not be in just one part of the world, but everywhere. As I have noted in previous posts, this presents the world with a problem. In environments of decelerating or contracting economies, everybody cuts down on consumption. Everybody wants to save. Everybody wants to earn cash inflow, but do not want cash outflow.

Everybody’s individual behavior, taken into the aggregate, results in further decelaration or contraction of economies. Businesses run out of clients. Businesses without clients lay off their workers. Laid off workers cut down on their spending further.

The first cutdowns are always in the most frivolous items. This will comprise much of the consumer items now being manufactured by the developing world. For businesses, the revenue cutdowns will result on supplier cutdowns. That means some outsourced processes that are now being done in bulk in the emerging world will be cut.

The most indispensable items for everybody are food, clothing and shelter. And of these, only food is a recurring expense item. Hence, in times of belt-tightening, only food items are really left for consumption. Countries that now have less emphasis in food production will continue to import their food at the same time that their revenues from exporting manufactured goods is slowing down.

Six months ago, economies the world over were reeling from commodity price inflation resulting from fast-growing demand the world over. But the resulting steep rise in food prices has caused demand destruction both in the developed and developing world. The bursting assets bubble and credit crisis has contributed to the slowing economies of the developed world, and the results of their slowing economies is creeping in as slowed growth, even contraction, in the developing markets.

There is an even greater threat to emerging markets in the medium-term. The threat is coming from the inevitable effects of the coordinated global monetary and fiscal actions being taken to address the credit crisis, which is rapidly spreading globally.

The monetary policy moves are creating an unprecedented increase in money supply. This will result in vastly increased inflation once economic activity starts growing again. The fiscal policy actions, meanwhile, are effectively transferring the world-wide purchasing power solely to citizens of the developed world, where much of the fiscal actions are taking place. Developing economies do not have similar capacities to stimulate local demand, especially as their slowing economic growth dampens government revenues. In the case of heavily-borrowed economies in the developing world, the credit crisis threatens to develop into national crises of their own.

What do you think will the likely effects be of increased money supply, and the sustained demand in the developed world, on global food prices? Yes, that’s right. Inflation will be back sometime soon in the food markets. And the worst lot will be suffered by the poorer economies, who will be lacking in foreign currency earnings, and hence, will have local currencies with poorer purchasing power.

So what can the emerging markets do at this point to keep from experiencing mass starvation in the very possible inflation ahead? Re-invest in agriculture.

The Japanese had it right. Even when the biggest contributor to growth had long been other sectors of the economy, the government still supported (subsidized, if you like) high-cost local food production. They rightly concluded that maintaining local food production is a matter of national security.

Re-invest in agriculture. Do it now before the cost of doing so goes up in two to three years.

Wednesday, October 29, 2008

Understanding why the US dollar remains the safe haven that it is necessitates that we understand the psychology and incentives of other developed nations. This is a very compelling piece by R. Taggart Murphy on why the US dollar remains the default currency reserve of the world. He maintains that the most likely contender for the role, the yen, is being consciously prevented by the Japanese from achieving such status.

Saori Katada poses a most compelling question: why does Japan continue to denominate so much of its accumulated export earnings in dollars? Supporting the dollar is largely a matter of using the dollar as the primary settlements and reserve currency for your foreign trade and investments, which the Japanese have done since 1945 -- first because they had no choice and then, from the early 1970s on, as deliberate policy…. Katada notes that there has been a good deal of talk emanating from Tokyo about the "internationalization" of the yen, but until Japanese companies begin to denominate their export earnings in yen -- which means billing foreign customers in yen and redeploying export profits in yen -- that's all it is: talk.

Murphy correctly points out that keeping the yen from attaining a substitute default standard to the US dollar has both costed the Japanese dearly, but has also enabled them to continue their policy of choice, which is to run trade surpluses.

Japan is the world's 2nd largest economy; it has been more than forty years now since the country needed to have any concern about its ability to afford essential imports...Why should such a country doggedly persist in a foreign exchange policy that looks as if it were drawn up for a weak, third world economy: hoarding "precious" foreign exchange as if any day now it couldn't pay for essential imports? Particularly when the dollar has lost more than two thirds of its value against the yen since the fixed link between the two currencies was cut back in 1973? And when Japan is facing a looming financial-cum-demographic crisis with a rapidly aging population and unfunded pension liabilities so large that the government has literally lost track of them? Those liabilities would be a lot less forbidding if Japan had systematically been salting away for the past few decades the earnings from its trade surpluses in yen and/or Deutschemarks and then Euros rather than in dollars.

Perhaps it's because those trade surpluses would not have been so large if Japan had switched from dollars 35 years ago. Katada argues -- and I would concur -- that that explains much. She notes not only the importance of the U.S. market to Japanese exporters -- billing American customers in any currency other than the dollar usually means losing those customers, something few Japanese exporters have been willing to risk -- but that most of Japan's other large trading partners in East and Southeast Asia also use the dollar as their primary external settlements and reserve currency.

So why do the Japanese allow its citizenry to remain stuck with a lower standard of living than they might otherwise enjoy by having a world-beating currency? Is it worth all the surpluses they end up with? Murphy explains further why:

A currency cannot be "internationalized" -- that is to say, widely used overseas -- unless it is available in sufficient quantities. Availability stems from outflows: either through the issuing country's current account of its international balance of payments, or through the capital account thereof. Outflows via the current account are, by definition, current account deficits. Outflows via the capital account mean that the country is deploying its surpluses overseas in its own currency in the form of loans to foreign borrowers, purchases of foreign bonds issued in the purchaser's currency, equity stakes in foreign companies, plant and equipment investments in foreign countries and so forth. But, for these loans and investments to make economic sense, the interest and dividend payments they generate -- not to mention principal repayments and profit repatriation -- have to be denominated in the currency in which the original investment or loan was made; otherwise they expose the investors to unacceptable foreign exchange risk. Thus the foreign entities that borrow the money or receive the investment have to have a way of earning the currency in which the loan or investment was originally made. As the foreigners use the capital deployed to make things or perform services that are sold back into the country that initially made the loan or the investment -- thereby earning the money needed to service the debt or repatriate the profits – the issuer of an international currency opens itself to the probability of periodic current deficits.

So the market took over from where the Japanese government was unwilling to do anything. Since they were unwilling to loan out their surpluses in the currency of would-be borrowers, the borrowers decided to borrow instead in yen. Who would be bold enough to take the currency risk? You’re right – speculators and hedge fund managers.

Among other things, there are now plenty of players prepared to find themselves short yen; that is to say, plenty of non-Japanese are now prepared to borrow yen. But that has nothing to do with long-term borrowings to build highways. It is opportunistic short-term borrowing by the likes of hedge fund managers who borrow yen at the next-to-zero interest rates that have prevailed since the mid 1990s and then flip the proceeds into a higher-interest currency such as dollars or baht. The practice is known as the "yen carry trade." The practitioners expect to profit from the interest rate differentials and bet that the yen will not appreciate significantly during the life of the borrowings. It's a license to print money provided, indeed, that the yen doesn't appreciate.

Another effect of the Japanese reluctance to de-dollarize their export earnings, according to Murphy, has been the decision to keep their earnings within the US financial system, which has been largely responsible for US ability to maintain military expeditions around the world, and I might add, for the US penchant to re-invest all this available liquidity in the latest asset bubble.

A systematic series of moves to "de-dollarize" as Katada puts it means dynamiting the key pillars of Japan's postwar political and economic framework: an economy structurally designed to generate current account surpluses, and the all-embracing alliance with the United States. By its willingness to hold its export earnings in dollars without seeking to exchange or repatriate them, Japan has left its export earnings inside the U.S. banking system, thereby automatically helping to finance American external deficits. Thus Japan has been the primary financial facilitator since the 1970s of the American ability to project military power around the world without crushing domestic tax burdens.

This is an unsustainable status quo, and both the dollar and yen will continue their extreme volatilities unless this is addressed. With the Japanese government still reluctant to take its long-due role on the world economic stage, what can we expect in the future? Murphy ends with: Of course the current meltdown on Wall Street -- not to mention the distinct possibility that a (new) administration may entrench the flailing, wild-eyed American militarism of the last seven years -- could well blow up that framework anyway without any help from Tokyo. But only then do I believe there will be any serious, thought-through effort to replace the dollar with the yen as Asia's pre-eminent currency.

Wall Street believes, often rightfully, oftentimes not, that its biggest assets are the ones who go down the elevator every evening. As a result, many firms are always apprehensive that, if unhappy, their biggest producers could leave any time to go to the first competitor willing to pay more.

These firms are fucked, whether it is their illiquid securities that do them in, or their departing producers that cause their downfall.

Good show, you people! You can’t even wait more than 2 weeks after receiving your bailout money before you announce the bonus plans. Do you even realize that many people are blaming you as a group for the current worldwide crisis?

In retrospect, the bailout should have probably been made after bonus season. The government could have avoided an unnecessary bonus war.

Thursday, October 23, 2008

OPEC countries are convening a meeting to discuss a coordinated decrease in oil production. The reason for this hastily convened meeting to decrease production is the steep and quick drop in the price of oil. Where it was at $147/barrel back in July, it is now at $67. An $80 drop in a matter of 3 months! OPEC nations are rightfully concerned.

But concerned enough to cut back on oil production? With the express motive of, not merely stopping the price drop, but bringing it back up? We know that Iran and Venezuela want to bring it back up to at least $100/barrel. They need it at that level in order to finance their respective domestic budgets. Any lower, and they are in danger of a fiscal crisis.

How did they arrive at their fiscal budgets? Oil only reached $100/barrel level at the start of this year. Did they automatically assume that that price level justified a suddenly bloated budget? Now that demand destruction has achieved the price declines that we are now seeing, these countries are panicking. And therefore want to bring it oil price back up to that level?

Before I explain why attempting to bring the price of oil back up is a big mistake, let’s go back to my first discussion on demand destruction. If the price of a commodity goes too high, many market participants will simply buy less, either by looking for close substitutes, or foregoing consumption altogether. In short, the price will eventually settle at a level where the market is able and willing to pay for oil.

The demand that is destroyed is not necessarily that coming from the most frivolous users. The demand that will be first to disappear is that coming from those whose purchasing capability is most stressed by the high price. It is they whose marginal propensity for oil consumption is steepest. As I had expected, the first to cut back on demand were:

1. The poorest people, i.e., those from the developing countries2. Companies the world over with the lowest profit margins3. Organizations that have only a fixed level of money for expenses, i.e., non-profits, NGOs, charitable organizations, municipal governments, etc.

Now that we are entering a severe global recession, the increased squeeze from artificially induced oil prices will no longer result in a cutdown on excess demand. It will result in a cutdown on crucial demand - from large and nationally-relevant industrial and business users necessary to keep global commerce from completely grinding to a full stop. Many of these are already reeling from an inability to secure adequate credit to buy their oil.

Higher oil price means less industrial production in many countries. Less industrial production means less jobs. Less jobs means lesser consumption. Lesser consumption means lesser production for still other countries who supply the originally destroyed consumption. And so on and on.

So let me repeat my warning back then - If governments, OPEC included, do not effectively manage the process of demand destruction, we may all end up with no demand at all.

Iran and Venezuela, just think what a possible absolute halt in demand for your oil would do to your respective budgets. Your problem will no longer be just a matter of selling your goods at a lower price, it would not being able to sell any significant amount at all. The complete breakdown in many national economies due to your moves will be on your conscience. And the wrath of your fellow OPEC members, who will also very likely suffer from such a breakdown in demand, will be all over you.

Tuesday, October 21, 2008

It all began with Ireland at the beginning of this month. Greece followed soon afterward. Now all nations are scrambling to follow suit. To not undertake a similar move would be tantamount to tilting the playing field in favour of those that do.

I am talking about providing absolute government guarantee on all bank deposits.

Now, in efforts to stem their biggest depositors from scrambling towards the country that guarantees all its deposits, all nations are forced to follow suit with their own versions of a deposit guarantee. In these times of crises and capitulating investor confidence, total and all-out guarantee is the name of the game. Today’s risk-averse depositors demand nothing less. Greece had announced that deposits "in all banks that operate in Greece" would be "absolutely guaranteed".

Are you a government who can’t afford, or refuse to guarantee all your local banks’ deposits, on grounds of principle? Then be prepared for the adverse consequence of losing them. Refusing to keep up in the new deposit guarantee arms race is a sure-fire way to cause a quiet bank run on your banking system. And that is the sure-fire way of ensuring your banks end up needing your government’s intervention.

So nations the world over are now figuring out how to recapitalize their Deposit Guarantee Institutions, and to legislate their own version of TARP. After all, TARP has had the unintended consequence of providing large depositors with a risk arbitrage – to take their deposits out of locales with low levels of deposit insurance, and into those that guarantee the whole lot.

This is an unprecedented escalation of economic warfare, where the government stands as the bazooka that enables its infantry banking institutions to decimate the competing banking army. In this new economic environment, guess who wins in the end? That’s right, the army that has the biggest bazooka.

Banks have since their inception battled to get the biggest and most credit-worthy businesses and firms as their clients. Traditionally, the richest individuals and the bluest of the blue chips have established their relationships with the largest, most stable banks. Now that the credit crisis has unravelled the belief that there are still stable banks out there, the implicit backing of the government has become the de facto gold standard of choosing where to bank.

But hey, if you’re a businessman, you’ve work hard to maintain your income in this difficult environment. The last thing you need is another matter to worry about, that the place where you maintain your checking accounts, receivables accounts, salary accounts, and savings accounts just might go under. So if you happen to have a subsidiary in Greece, then all is well.

Similar arbitrage opportunities could be exploited by enterprising nations in other regions of the world. This could prove to be a golden opportunity to attract capital at low cost. Who would have thought we’d get to a point where a competitive advantage of a country would include its government’s capability and willingness to step in and be the guarantor of last resort.

Of course, not all countries are made equal. Some will have a more solid fiscal footing than others. Some will have a deeper currency reserve than others. Some will have a more stable banks, and much bigger local firms. As a result, not everyone will provide for absolute guarantee.

But then again, which country really has the financial footing to guarantee all of its deposits? The bigger the deposit base, the bigger the potential liability. At the end of the day, what we have ended up doing is taking the derivative risk management game up a notch, to the level of national governments.

Investors and bankers in the last decade thought they had prudently and magically rid themselves of credit and default risks by entering into various credit default swaps, buying default insurance, and entering into ever more elaborate cross-party guarantee schemes. At the end of the day, these risk management schemes unraveled in a black swan event where the biggest, most inter-related counter-parties suddenly failed.

Could another black swan event happen to unravel the financial thin ice of absolute government deposit guarantees? If none is obvious in forthcoming, bad times could be ahead for those governments that do without it.

Friday, October 17, 2008

It’s becoming more evident that the most useful effect of the US Treasury’s capital infusion into the banks is not to jumpstart lending, but to enable these banks to attract more private capital. Illustrating that the infusion is not likely going to result in more immediate lending, here’s a New York Times article.

On Monday, Mr. Paulson unveiled plans to provide $125 billion to nine banks on terms that were more favorable than they would have received in the marketplace. The government, however, has offered no written requirements about how or when the banks must use the money.

The banks could use the money from the government for any number of things. Some analysts say the banks may use it to acquire weaker competitors. Others say they might use it to avoid painful cost-cutting. And still others say the banks may sit on the capital.

Lenders have been pulling back on credit lines for businesses, mortgages, home equity loans and credit card offers, and analysts said that trend was unlikely to be reversed by the government’s money.

“I don’t think that the market wants to see that capital being put to work to leverage the business up again,” said Roger Freeman, an analyst at Barclays Capital. “My expectation is it’s quarters off, not months off, before you see that capital being put to work.”

“It’s clear that the government would like us to use the capital,” Mr. Dimon (JP Morgan) said on a conference call with analysts on Wednesday. “If you are a bank that is filling a hole, you obviously can’t do that.”

Bank of America said in a statement that the money “will add to our capital, which will increase our capacity to expand our balance sheet and make more loans.” It did not say if it was willing to increase its lending.

“We will have the opportunity to redeploy that,” Mr. Thain (Merrill Lynch) said of the new capital on a telephone call with analysts. “But at least for the next quarter, it’s just going to be a cushion."

However, given that these banks now have more cushion against further possible writedowns, it is now possible for new investors from the private sector to come into these banks without fear of being wiped out.

And as this article from Bill Poole indicates, it is in the interest of these same banks to seek new private capital, to be able to buy out the government as soon as possible.

Banks will not want to play this game. Treasury's new program provides that a bank can exit by repurchasing Treasury shares with newly raised private capital. Given the program's distasteful features and future dangers, banks may want to exit as soon as they can to escape potential federal intrusion into their lending practices.

Bill Poole argues that not using the infusion to immediately increase lending is justifiable, and prudent.

Some banks need more capital not to expand lending, but to shore up the existing balance sheet. It would be a terrible mistake for Treasury to direct banks participating in its capital-infusion program to expand credit in particular directions, or in the aggregate. Exhibit A: Fannie Mae and Freddie Mac, both now wards of the state. Do we need further exhibits? Federal credit allocation will be an unmitigated disaster.

Treasury Secretary Hank Paulson was quoted by Bloomberg on Tuesday as saying that "leaving businesses and consumers without access to financing is totally unacceptable." Actually, it is perfectly acceptable to leave certain businesses and consumers without access to credit. Everyone understands that we would be a lot better off today if the market had denied mortgage credit to many subprime borrowers.

Treasury chose to infuse healthy banks first because unhealthy banks were not likely to volunteer themselves as participants in the plan, given that the move itself is a red flag to its own depositors and investors.

Because participation carries terms objectionable to banks, such as limits on executive compensation, only weak banks will want to participate willingly. If some banks participated and others did not, those who did would be in effect declaring they were weak and scaring away depositors and investors.

The stigma argument does carry some weight. But the way to deal with it is for participating banks to raise private capital as well as Treasury capital -- so that they can demonstrate that they are unquestionably solvent and strong. One way to demonstrate strength would be to hold capital clearly in excess of the regulatory minimum.

You can be sure that the first banks to raise private capital and get out of the Treasury plan will be the ones most likely to thrive when the crisis has been contained. Just don’t expect them to start a massive lending program anytime soon, and never at the same licentious levels as before.

More likely, The Fed's decision to pay interest on reserves will be more effective in stimulating lending, albeit among banks. By paying interest on all bank reserves placed with the Fed, the Fed is now using the reserve as a way to mop up excess liquidity from the financial system. In today’s credit contraction environment, this allows the Fed to collect the excess liquidity that is otherwise not being lent out by banks, and use it to lend to those banks needing Fed loans. By using the liquidity that is already out there, but trapped within each bank, it minimizes the Fed’s need to increase money supply every time a bank uses the discount window. Voila, the Fed is now the conduit bringing back inter-bank lending.

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"Conventional approaches, unconventional conclusions" on the global finance and economic issues of the day. Rogue Econ has been a banker and financial consultant in several countries. Welcome to my blog.